Government bonds: caution ahead

Geopolitical forces suppressing global government bond yields have somewhat
dissipated after the French first-round vote. We see Fed rate rise expectations
returning as a bond market driver, justifying a cautious stance on sovereign debt.

The business-friendly Emmanuel Macron’s clear first-round presidential election
win reduced near-term European political risk. Markets are now pricing in nearly
1.5 additional quarter-percentage-point rate increases this year, but we think they
still underestimate the Fed’s resolve to tighten policy.

Focus returns to the Fed

The Fed has made clear it views the U.S. economy as nearing the central bank’s employment and inflation goals and accordingly
plans to stay on a gradual normalization path. We expect global government bond yields to rise – and prices to fall – as market
expectations catch up to our base case of two more Fed rate increases this year.

Strong demand for income and still-accommodative central bank policies in much of the world should help keep rises in yields
moderate, in our view. We do expect to see a steepening of the yield curve over time, with very long term yields in particular set
to rise as we move from a period of accelerating growth to a new phase of sustained economic expansion.

We see yields on bonds with durations of five years or less as vulnerable in the near term to any jumps in Fed tightening
expectations, and we are underweight U.S. Treasuries and European sovereign bonds. Bullish sentiment following the French vote
sparked selling of safe-haven assets. Rising European growth and inflation, and the prospect of a less supportive European
Central Bank (ECB), may help push European and global yields higher. We expect the Bank of Japan (BoJ) to stay on hold until we
see meaningful Japanese growth and inflation.

Focus

Opinion Psychology and smart beta

‘Smart beta’ sounds like an oxymoron. How smart can it be to continue using the same strategy in such fickle markets? A portfolio manager calling on all his skills (‘alpha’) in analysing market environments (the source of ‘beta’) should be able to outperform an unchanged (...)